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September 2019 saw a ‘liquidity crisis’ in the US repo market, a market principally operated by private banks. This liquidity stress led to a spike in funding costs. As a response, the Federal Reserve intervened through cash injections to restore an operational normality to this market.
The last time this event occurred was in 2008 at the height of the financial crisis. Back then, two main causes for this malfunction had been identified: a mistrust between commercial banks in their interbank lending operations and a growing discomfort on the collateral proposed for repo transactions (especially collateral backed by real estate loan portfolios. The US property market was in turmoil in 2008).
The September 2019 funding stress was a surprise to many. Present-day economic conditions are a far cry from the subprime meltdown eleven years before. In addition, Fed policy had been recently adjusted with the end of ‘Quantitative Tightening’ program in August. Yet despite this preemptive monetary action, the liquidity made available as a result seems to have been grossly inadequate.
New York Fed’s ex-President Bill Dudley provided his account of the current repo situation. He pointed to the corporate tax payment season and recent treasury auctions as having dried up market liquidity. These explanations have left many perplexed. Why could such liquidity flows not have been anticipated by the Fed? What other reason would eventually lie behind the present funding crisis in the repo market?
To delve deeper into this phenomenon, certain analysts have put forward structural arguments, based on recent world Central Bank policy, as well as other cyclical events. The first structural issue concerns the collateral used in the repo market. Traditionally, this kind of financial transaction uses US government bonds as collateral because they are considered to be the best quality instrument available. Since 2008, Central Bank interventions have progressively soaked up government debt making them more difficult to come by.
As a result, more and more corporate bonds are being put up as collateral in repo transactions instead. However, corporate debt is considered to be of lower quality by dealers in this market place. Following recent economic data showing a downturn in world activity, corporate bonds are being increasingly perceived as carrying a higher risk than in previous months. This has led to a rise in their risk premium and by extension the funding cost for those who use them as collateral.
The second structural issue involves around bank reserves. American Banks have been encouraged through regulation and the remuneration of their deposits to park their excess liquidity as reserves with the Fed rather than make it available as funding for the repo market.
In sum, the US repo market has been exposed to decreasing collateral quality and uncertain funding flows for its large banking liquidity providers. To top it all, additional cyclical factors have come into play.
International demand has been increasing for US dollar cash and fixed income assets, over the last few months. Geopolitical uncertainty in Hong Kong and the Middle East, rising bond prices on the back of lower US interest rates, plus international investment capital desperately seeking yield, have combined to disrupt the traditional bond and liquidity flows associated with the repo market. All these structural and cyclical elements seem to have come to a head in September 2019.
In a recent interview, Jeffrey Gundlach from DoubleLine described how the repo market has been under pressure since the end of 2018. He believes this situation could last for a while longer and he views the recent Fed liquidity injections to be on the road to fresh asset purchases by the American central bank.
Michael Howell of Crossborder Capital brings a different perspective to this liquidity crisis. For him, monetary accommodation in Europe, China and Japan must be viewed in the context of a currency war against the US dollar. He anticipates the Trump administration and the Fed will not be able to allow the current liquidity stress to last for any period of time. He believes the Fed will have to react at some point by opening up more aggressively the liquidity channels, notably for the US repo market.
Column by Steven Groslin, executive board member and portfolio manager at ASG Capital